A COST BENEFIT ANALYSIS OF INITIAL PUBLIC OFFERINGS
OF EQUITY REITS AND PROSPECTS FOR GROWTH IN THE INDUSTRY
by
Oliver T. Carr, III
Bachelor of Arts in Urban Studies
Trinity College
(1987)
SUBMITTED TO THE DEPARTMENT OF URBAN STUDIES & PLANNING
IN PARTIAL FULFILLMENT OF
THE REQUIREMENTS FOR THE DEGREE OF
MASTER OF SCIENCE IN REAL ESTATE DEVELOPMENT
at the
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
July 1992
(c)
Oliver T. Carr, III
The author hereby grants to MIT permission to reproduce and
to distribute publicly copies of this
thesis document in whole
or in part.
Signature of Author
Oliver T. Carr, III
Department of Urban Studies & Planning
July 31, 1992
Certified by
Marc'A. Louargand
Lecturer
Departmen t of Urban Studies & Planning
Th sis Supervisor
Accepted by
Lawrence S. Bacow
Chairman
Interdepartmental Degree Program in Real Estate Development
RotWn
MASSACHUSETTS INSTITUTE
OF TECHNOLOGY
,SEP 02 1992
LIBRARIES
A COST BENEFIT ANALYSIS OF INITIAL PUBLIC OFFERINGS
OF EQUITY REITS AND PROSPECTS FOR GROWTH IN THE INDUSTRY
by
Oliver T. Carr, III
Submitted to
July 31, 1992
the degree of
the
the Department of Urban Studies & Planning on
in partial fulfillment of the requirements for
Master of Science in Real Estate Development at
Massachusetts Institute of Technology
ABSTRACT
This thesis examines the costs and benefits associated with
initial public offerings of equity real estate investment
trusts (REITs) and attempts to determine the prospects for
growth in the equity REIT industry.
In today's commercial
real estate marketplace, which is struggling with illiquidity
and a lack of access to capital, the equity REIT vehicle has
received a great deal of attention as a potential solution for
many of the current problems.
Both private developers and
institutional owners of real estate are considering the equity
REIT as a way to access much needed capital and offer the
tradeable, liquid real estate vehicle which investors are
demanding. However, the benefits associated with equity REIT
ownership do not come without costs. There are substantial
impediments in the market today limiting the entrance of new
equity REITs. Growth in the industry will primarily depend
on the ability of the private owners of real estate to
overcome the impediments to equity REIT formation, and will
depend on the role of the traditional financing sources.
To offer a full perspective on the state of initial public
offerings of equity REITs, an attempt was made to gather
information from different aspects of the industry including
a private developer working through the offering process for
a public equity REIT, the former chairman of a public real
estate operating company, an investment bank, institutional
real estate advisors, and consultants to the REIT industry.
The insight of these individuals, in combination with
viewpoints from the extensive literature written on the REIT
industry, has contributed to the content of this thesis.
Thesis Supervisor:
Marc A. Louargand
Title:
Lecturer
Department of Urban Studies & Planning
Acknowledgements
I would like to thank Robert Frank and the entire real estate
equity research area of Alex. Brown & Sons, Inc. in Baltimore
for all of their assistance.
This thesis is dedicated to my wife, Bonnie, for giving me the
inspiration and support which I needed so much of in the past
year.
TABLE OF CONTENTS
Page
CHAPTER
1. INTRODUCTION
Purpose and Methodology of Thesis ........
Real Estate Investment Trusts.............. ---
.
--
.
6
-l
2. OVERVIEW OF EXISTING LITERATURE
The Demand for Liquidity as a Catalyst for
REIT Growth ................................ T - - -- - - The Benefits to the Owner of an Equity REI T IPO ..The Foreign Precedent ....................
...............................
Conclusion
3. THE COSTS AND MARKET DRIVEN REQUIREMENTS
FOR AN EQUITY REIT IPO
29
Offering Specifications ...................
Conversion
&
Issues
Driven
Other Market
Timetable ................................... -----. . 46
Additional Points from Interview With
- 52
...........................
William Byrnes
4. OTHER PERSPECTIVES
Part One: The Private Developer Engaged in
the Offering Process .............................
Part Two: The Legal Perspective ...................
Part Three: The Independent REIT Advisor .........
Part Four: Perspective of a Former President
and CEO of a Real Estate Operating Company .......
57
63
68
72
5. THE FUTURE ROLE OF PENSION FUND INVESTMENT
PERSPECTIVES OF TWO
IN THE REIT INDUSTRY:
INSTITUTIONAL ADVISORS
The Institutional Advisor Specializing in
REIT Investment ..................................... 77
Another Institutional Advisor Perspective ........ 82
6. CONCLUSION:
THE PROSPECTS FOR GROWTH
BIBLIOGRAPHY & REFERENCES
............ .. 86
............................. 89
LIST OF FIGURES
Page
FIGUR E
1. Total Return Comparison: S&P 500 VS
NAREIT Equity REITs .................
2. The REIT Industry in 1991
..
..................
3. REITs % Discount to Current Value
.......... ........
13
21
4. Total Return Comparison: Russell NCREIF VS
NAREIT Equity REITs .................
. 24
...............
27
5. The Global Property Universe
30
6. IPO REIT Expenses and Offering Parameters
7. IPO Equity REIT Property Valuation Discount
8. Sample REIT Offering
........
....................... ..
39
9. Summary of IPO REIT Issues
.
..
................. ........
10. Annual Contributions & Redemptions for Selected
Open-End Commingled R.E. Funds .......... ....
45
56
79
CHAPTER 1:
INTRODUCTION
Purpose and Methodology of Thesis
The purpose of this thesis is to examine the costs and
benefits of initial public offerings of equity real estate
investment trusts (REITs) and to determine the prospects for
In my opinion, this is
growth in the equity REIT industry.
a timely topic, as the commercial real estate industry today
is
struggling with
capital.
and
illiquidity
a
lack
of
to
access
In addition, the industry is currently undergoing
a transformation to a closer relationship with the capital
markets,
primarily
driven
by
the
Many private and
securitization.
advent
of
real
estate
institutional owners of
commercial real estate are looking to securitization, and
equity REITs in particular, as a panacea to solve all of their
problems.
However, the benefits associated with equity REIT
formation
do
not
come
without
their
There
costs.
are
substantial impediments in the market today limiting the
entrance of new equity REITs.
William
Newman,
the
Chairman
of
the
Association of Real Estate Investment Trusts, Inc.,
National
and the
Chairman of New Plan Realty Trust, accurately described the
outlook for the REIT industry in the following statement:
Securitized real estate, as represented mainly by the
REIT vehicle, is virtually the sole means of raising
capital today for the real estate industry. We expect
our industry to grow and prosper in the '90's and to
provide some of the liquidity missing from the real
estate industry today.1
Mr. Newman's statement offers an optimistic view for the REIT
Over the past three to four
industry which is well founded.
years,
the traditional sources
real estate
of non-recourse
financing have evaporated from the marketplace in the face of
over-built
markets
the
and
commercial real estate.
severe
decline
valuation
of
In addition, private sources of debt
and equity financing have retreated from the marketplace as
well.
These private sources have learned the painful lessons
that real estate values can decline and that real estate can
experience volatility as an asset class [42].
Liquidity is
gone, even for investment vehicles which promised to honor
reasonable withdrawal requests, and the performance of most
institutional real estate portfolios now falls short of cash
equivalent returns [45].
In the face of the dire state of the commercial real
estate
industry,
a
rush
is
underway
currently
from
both
private developers and institutions to take private holdings
public through the equity REIT vehicle.
One author stated
that 1992 could see the biggest wave of new REIT offerings
since the mid-Eighties [48].
However, there are significant
impediments to equity REIT securitization.
This is evidenced
by the fact that the initial public offering (IPO) of Kimco
Realty
Corporation
in
November
of
1991
was
. Coopers
& Lybrand,
REITs: The Future
Perspectives of Industry Experts, 1992, p. 6.
the
is
first
Now,
successful equity REIT IPO since August of 1988 [10].
In
brief,
the
impediments
to equity REIT
formation
include the public market's lower valuation of property, the
hard dollar costs of an IPO1,
the cultural changes to take a
private company public, and the individual partner issues (if
a partnership is being converted to a REIT).
focuses
on
equity
REITs
in
particular
This thesis
because
they
are
receiving the most attention from investment banks and owners
of commercial real estate as a potential investment vehicle. 2
In addition, investor interest in equity REITs is growing as
they have generated total returns comparable to the S&P 500
since 1978 with approximately 11% less volatility (See Figure
1).
The methodology involved in preparing this thesis was
a combination of
literature
research
professionals in the REIT industry.
and
interviews with
Literature was reviewed
to access the state of the equity REIT market and to research
the existing views from the industry concerning the costs and
benefits
of
equity REIT
formation.
Interviews were
then
conducted to test existing theories and to gain first hand
knowledge of the current state of the equity REIT IPO market.
I Hard dollar costs include any cash expenses involved
with a public offering such as underwriting fees, appraisal
costs, accounting charges and legal fees to name a few.
Mortgage REITs acquired a bad reputation in the mid to
late 1970's when the rapidly rising cost of funds turned
earnings negative. During this time period, share values of
mortgage REITs fell precipitously. Mortgage REITs have
continued to be out of favor since that time [8].
2
8
Figure 1.
Total Return Comparison
S&P500 VS NAREIT Equity REITs
700
600
500
400
300
200
100
1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
+ S&P 500
+ NAREIT Equity REITs
12/31/77 = 100
Data From 12/77 to 3/91
Source: NAREIT, S&P Corp
An
attempt was made to gather
information from different
aspects of the industry including a private developer working
through the IPO process for a public equity REIT,
chairman
of
a public
investment bank,
real
estate
institutional
consultants to the
real
REIT industry.
operating
estate
The
the former
company,
advisors,
insight of
an
and
these
individuals, in combination with viewpoints from the extensive
literature written on the REIT industry, has contributed to
the content of this thesis.
10
Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts are essentially pooled
ownership vehicles
Similar
stock
to
shareholders of
negligible
for
investment
ownership
REITs may
liability.
In
in
enjoy
in
real
any
assets.
corporation,
a liquid
technical
estate
the
investment with
terms,
a REIT
is
a
corporation (or a business trust or other association taxable
as a corporation) that is able to pass its earnings through
to
shareholders
free
of
corporate
tax.
This
"conduit"
treatment is available provided that the REIT distributes
virtually all of its income to shareholders and complies with
various requirements designed to compel it to specialize in
real estate ownership or finance [40].
were viewed as passive
merely
manage
existing
Traditionally, REITs
real estate operators which would
portfolios.
However,
REITs
are
increasingly being viewed today as operating companies with
significant capacities to add value to holdings through active
management, acquisitions, and redevelopment.
REITs take several different forms including equity
REITs which invest directly in commercial property, mortgage
REITs which invest in or originate commercial mortgages, and
hybrid REITs which have a combined portfolio of debt and
equity
real estate holdings.
As of June
1991,
the
REIT
industry had total assets of $45.42 billion which was made up
of $16.34 billion of equity holdings and $25.87 billion of
debt instruments (other assets totaled $3.21BN at 6/30/91).
Total equity capitalization of the REIT market as of June 1991
was just over $15 billion (See Figure 2) [41].
The majority
of REITs are publicly traded on U.S. stock exchanges while
the private
a market
capitalization of
approximately $4 billion as of June 1991.1
Private REITs can
be
REIT
exchanged
industry had
only
between
qualified
investors
typically placed with pension fund investors
private REITs may
illustrate the
and
[22].
application
are
"Such
of the REIT
structure as a form of commingled fund for pension plans." 2
However,
private
may
REITs
desired
transferability
not
due
offer
to
the
the
liquidity
limited
number
and
of
investors.
The concept of the real estate investment trust goes
back to the 1880's when the trusts were originally created to
avoid taxation at the corporate level.
At that time, the
trusts were not taxed if income was distributed through to the
beneficiaries.
all
that
organized
However,
passive
and
in the 1930's the Supreme Court ruled
investment vehicles
managed
corporations [3].
like
that were
corporations
be
centrally
taxed
as
With this ruling, the early trusts lost
their advantageous tax status.
The modern REIT was born in the post World War II era
A REIT qualifies
registered with the SEC.
as
being
public
if
it
has
been
Robinson, Thomas E.,
"REITs Revisited:
Growing
Prospects in the 1990s," Real Estate Accounting & Taxation,
Winter 1992, p. 35.
2
12
Figure 2.
The REIT Industry in 1991
As of June 1991, the National Association of Real Estate
Investment Trusts, Inc. (NAREIT) reports the existence of 187
companies that qualify as REITs under the federal tax laws.
Of these, 123 have stock that is listed and actively traded
on the New York and American Stock Exchanges or on NASDAQ/NMS.
REITs that engage primarily in the ownership of real estate
("equity REITs") number 118, while 37 emphasize investment in
mortgages and mortgage-backed securities ("mortgage REITs")
and 32 have balance sheets that reflect a combination of the
basic investment strategies ("hybrid REITs"). Approximately
21 % of the public equity REITs are healthcare REITs.
Industry analysts typically view healthcare REITs as a
separate type of asset because of their reliance on the
healthcare industry [41].
Industry Balance Sheet
(June 1991, $ Billions)
Liabilities
Assets
Equity Investments
Property Owned
(net of deprec.)
Other
$14.54
1.80
Total
$16.34
Mortgages
First Mortgages
Mortgage Pools
Other
Liabilities
$ 4.26
Mortgages
16.36
Mortgage bonds
1.03
Convertible Debt
1.79
Nonconvertible Debt
4.64
Bank Debt
2.14
Other
$ 6.23
Total Liabilities
$30.22
18.41
1.23
Total
$25.87
Other Assets
$ 3.21
Total
$45.42
Shareholders Equity $15.20
Total
13
$45.42
when the increased demand for real estate equity and mortgage
funds
sparked
interest
renewed
investment vehicle.
in
a pooled
real
estate
A campaign was begun to achieve special
tax considerations for REITs which had already been afforded
to mutual
funds.
In
1960,
legislation
was
passed
which
treated REITs as a conduit to pass taxable income through to
beneficiaries avoiding tax at the corporate (trust) level if
certain set requirements were met [3].
This new legislation
was further refined by legislation in 1976 and 1986 which
modernized the REIT regulations to their present form.
The requirements put in place by Congress to govern
REITs were clearly aimed at limiting REITs to a passive real
estate ownership role.
as
developing
property
Typical development activities such
for
sale,
third
party
property
management and land sales are restricted by the legislation.
A summary of the tax code requirements to which REITs must
conform to maintain their tax free status follows:
1. A REIT must be organized as a corporation or business
trust which is taxable as a corporation.
2. The REIT must have fully transferable shares (either
privately or publicly held).
3. REITs must have a minimum of one hundred shareholders
and may not be closely held.
4. No more than 50% of the REIT shares may be held by
five or fewer individuals during the last half of each
For the purposes of the tax code,
taxable year.
"individual" is defined to also include U.S. pension
funds, private foundations and charitable trusts.
At least seventy-five percent of total assets must
5.
be invested in real estate assets which include real
property, loans secured by real estate, mortgages, shares
14
of other REITs, cash or government securities. REITs may
not hold other non-real estate assets which constitute
more than twenty-five percent of total assets.
At least seventy-five percent of a REIT's gross
6.
income must be derived from rents or mortgage interest
In addition,
and gains from the sale of property.
from these
be
must
income
gross
of
ninety-five percent
sales of
the
from
gains
dividends,
plus
sources
securities and interest income. Rental income will be
disqualified if derived from a tenant in which the REIT
directly or indirectly owns a ten percent or greater
interest.
7. No more than thirty percent of gross income can be
derived from the sale of properties held less than four
years, securities held less than six months or other
prohibited transactions.
8. A REIT must distribute at least ninety-five percent
of its ordinary income as dividends to shareholders. It
has the option to retain or distribute capital gains,
but undistributed gains are subject to entity level tax
[22,41].
The current market for REITs is primarily driven by
retail investors who have invested in REITs for their income
producing attributes.'
Although institutional
interest in
REITs is growing, pension fund investment has been limited by
the five or
fewer rule and by the relatively small total
capitalization of the REIT market
[8].2
However, REITs do
offer tax-exempt investors exemption from unrelated business
income tax (UBTI) and liquidity.
I Retail investors include individual investors buying
Institutional
shares through retail brokerage firms.
mutual funds,
include
investors, on the other hand, typically
investors.
corporate
other
and
pension funds
No more than 5 individual investors can own more than
50% of the outstanding stock of a REIT. This requirement is
commonly referred to as the "five or fewer rule."
2
15
Most of the publicly traded equity REITs have at times
traded at a substantial discount to net asset value. 1
This
phenomenon has been driven primarily by the difference between
appraisal based and public market valuations of commercial
property and the market's negative perception of real estate
as an asset class.
The public markets tend to base valuations
primarily on the income streams of properties and severely
discount any residual value of the assets.
However, some
equity REITs have traded at premiums to net asset value as the
market has rewarded competent management and income producing
acquisition strategies.
The outlook for dramatic growth in the industry, such
as
that held
by
Alex.
Brown
& Sons
which
forecasted
an
expansion in the industry from $40BN in assets to $400BN by
the end of the decade, is primarily driven by the supply side
of the equation [11].
private developers,
The assumption has been made that
and institutional advisors with extensive
real estate holdings under management, will take these assets
public and thus grow the industry substantially.
However,
very little discussion has been focused on the buy (demand)
side.
At present, institutional investment in REIT's has been
limited
with
public
pension
fund
investment
totalling
approximately $2 billion [38].
1
This experience has been recorded with corporations
REITs.
as
well
as
partnerships
traded
and publicly
Discounting of partnership prices has been especially severe
in the wake of tax legislation in 1987 and 1988 designed to
limit the use of publicly traded partnerships [17].
16
CHAPTER 2:
OVERVIEW OF EXISTING LITERATURE
The Demand for Liquidity as a Catalyst for REIT Growth
The majority of authors who have written about the
current state of REITs, and the demand for securitized real
estate in general, have focused on the prospects for growth
in the industry.
These growth expectations for REITs, and
equity REITs in particular, are driven by the demand of the
private owners of real estate for liquidity.
Several authors,
including Giliberto, Robinson, and Frank, have suggested that
REITs will fill the financing void left by the retreat of the
traditional
sources
of
financing
[22,40,11].
These
traditional sources include commercial banks and insurance
companies, which have virtually cut off all means of financing
for commercial real
estate.
In addition, syndicators are
almost completely out of the picture.
Due primarily to the
lack of other financing sources in the market, Alex. Brown &
Sons forecasts that the REIT industry will grow by tenfold by
the end of the decade [11].
Although this estimate appears
a bit optimistic on the surface, the REIT industry has grown
from $9 billion in assets in 1985 to $45 billion today [14].
The catalyst for this growth was the passage of the Tax Reform
Act of 1986 when owners turned from partnerships to REITs as
a way to raise capital.
Today, the catalyst for REIT industry
expansion is the lack of other capital sources in the market.
The idea that REITs will fill the current financing
void for commercial real estate may be valid.
It is evident
that
a
new
source
of
liquidity
is
in
needed
marketplace and as Robert Frank pointed out,
today's
"historically,
the most efficient way to transfer capital from surplus areas
to deficit areas has been through the securities markets."'
In addition, the need for capital will force the recognition
of
the
public
market's
pricing
implicit
of
virtually
all
commercial real estate assets [22].
In
a recent
Director of Real
David Shulman,
interview,
the Managing
and Economic and Market
Estate Research
Analysis with Salomon Brothers, indicated that the growth in
the REIT industry should be long-term due to the fundamental
changes which the real estate industry has undergone in the
last six years [8].
Shulman believes that real
Specifically,
estate has been a private business due to the availability of
non-recourse debt financing and tax benefits [8].
In today's
environment, the tax benefits are gone, primarily due to the
passage of the Tax Reform Act of 1986, and the ability of
private real estate owners to obtain non-recourse financing
has been severely diminished.
It
some permanence,
so
will
have
financing vehicle will emerge.
structure will fill
is
it
likely that these changes
is
logical
that
a new
Shulman believes that the REIT
the long-term capital needs of commercial
real estate primarily because of the tax transparency of the
I Creswell, Catherine C., Frank, Robert A., Hillers,
Samuel T., The Regional Equity REIT: The Growth Segment of the
U.S. Real Estate Capital Markets, March 30, 1992, p. 4.
18
REIT as an investment vehicle [8].
In addition to the fundamental changes in commercial
real estate which Shulman has pointed to as a catalyst for
equity REIT growth, the growth of the tax-exempt, unlevered
pension
investors'
ownership vehicle.
real
estate
position
argues
for
a new
Pension investments in commingled funds
and separate accounts have not delivered the
returns originally intended.
liquidity or
Pension plans are looking much
more critically at their advisors and their holdings today,
and are
demanding a real estate investment which offers
liquidity and market valuation.
This demand may cause
a
tremendous conversion of private institutional holdings into
However,
public ownership vehicles, namely equity REITs.
the conversion of real estate holdings from private to public
has its own set of impediments at the institutional level as
well,
including valuation and cultural issues.
It
is unclear
at this point whether advisory firms will be willing to accept
the
public
management.
market's
valuation
of
their
assets
under
Even if only a portion of an advisors portfolio
is securitized, it will likely cause a revaluation of all of
their comparable holdings.
Other industry practitioners, such as Jon Fosheim of
Green Street Advisors, have stated that growth in the equity
REIT industry will be heavily dependent on the private owners'
of real estate willingness to accept the lower valuations
offered by the securities market [48].
The public market sets
for the
the price
may bear
and that pricing
property,
no
relation to the original cost, or to a current appraisal [48].
traded
typically
have
REITs
in
the
markets
public
at
a
discount range of ten to fifty percent of current asset value
with an average discount close to twenty-five
since 1981,
(See
percent
Figure
[44].'
3)
As
of
July
1991,
these
discounts were closer to thirty percent as the public markets
tend to overreact to particular downtrends or uptrends in the
real estate economic cycle
[45].
However,
several public
equity REITs have traded at premiums to current asset value
primarily
portfolios
due
and
to
the
sustained
favorable
earnings
income
of
growth
their
For many
projections.
institutional and private owners of commercial real estate
considering going public, the valuation discounts offered by
the public markets have been difficult to accept and have
served as one of the barriers to securitization [34].
2
The Benefits to the Owner of an Equity REIT I.P.O.
Most authors have pointed out that the primary benefit
of the equity REIT structure to a private owner of real estate
is access to liquidity and the capital markets
[8,11,15].
This liquidity can benefit the private developer who needs
Current asset value refers to a valuation of the
I
commercial properties by a current appraisal. Historically,
there has been a difference between the appraisal based value
of the assets held by REITs and the valuation assigned to
those same assets by the public markets.
2
I.P.O. stands for Initial Public Offering.
20
Figure 3
REITs % Discount to Current Value
(Scale Inverted)
50 -
45 40 35 30 -
25 20 15 10 51
1
1
I
I
1
1
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992
21
Source: Ken Campbell, Audit Investments, Inc.
access to capital and can benefit advisory firms which are
trying to meet investors redemption requirements.
As Milton
Cooper, the Chairman of Kimco Realty Corporation' stated:
We (Kimco) didn't want to rely on traditional lending
sources. We were looking to see how we could create
another form of ownership where capital would be
available on a regular and continuous basis.2
Another benefit associated with access
is the
to capital
ability of private owners to reduce outstanding debt.
This
benefit is crucial in today's marketplace.
Thomas Robinson, the head of REIT Advisory Services
for Coopers & Lybrand, has stated that liquidity should not
be the only reason that a private owner should choose the REIT
as an ownership vehicle [14].
Instead, the owner should focus
on the long-term growth opportunities associated with REITs
and not just look for a quick fix.
a unique
REITs have
opportunity in this market to raise capital for acquisitions,
gain market share, and provide solid long-term growth for
owners.
An
estate
additional
benefit
for
private
that take their holdings public
associated with public ownership [8].
is
owners
the
of
real
discipline
Due to the disclosure
requirements associated with public ownership, expenses must
be controlled and REITs must be run efficiently to gain market
Kimco Realty Corporation is a publicly traded equity
REIT which went public in November of 1991.
Coopers & Lybrand, REITs:
The Future
Perspectives of Industry Experts, 1992, p. 15.
2
is
Now,
acceptance.
While these requirements may
appear to be a
burden, several private owners have stated that the discipline
required of a public REIT forces the companies to operate
efficiently which is obviously a positive [1,8].
Another benefit of the equity REIT to private real
estate owners is the ability of the REIT vehicle to attract
tax-exempt
investors
(pension funds).
Although the REIT
industry's capitalization at present is too small to attract
the larger institutional investors, the equity REIT does offer
some obvious advantages to pension funds.
These advantages
include a more efficient valuation of real estate assets than
has been the experience with direct investment.
Appraisal
smoothing has been well documented and investors have accepted
the fact that appraisal-based valuations are not currently
realizable
[42,48,9].
In
addition,
equity
REITs
have
outperformed direct real estate investments (as measured by
the Russell-NCREIF Index') by 53% on a total return basis from
1978 through the 1st quarter of 1991 (See Figure 4).
One
author
stated
that
REITs
can
also
offer
institutional investors much needed liquidity and corporate
governance [8].
However, real liquidity will only be attained
through a widely held-public REIT vehicle.
Private REITs
The shortcomings of the Russell-NCREIF index including
the issues of appraisal smoothing and lagged valuations, in
addition to an inconsistent property index over time, have
been well documented.
However, this index remains the
industry standard for measuring the returns of institutionally
owned real estate.
Figure 4.
Total Return Comparison
Russell-NCREIF Index VS NAREIT Equity
600
500
400
300
200
100
111111111
011111&111R11
1978 1979 1980 1981 1982 1983 1984 1985 1986 1987
-*- Russell-NCREIF
12/31/77
-a- NAREIT Equity
= 100
Data From 12/77 to 3/91
Source: Russell NCREIF, NAREIT
1991
offer more liquidity than direct ownership of a property, but
will offer much less liquidity than a public REIT depending
on
the
number
institutional
of
shareholders.
investor
to
The
achieve
ability
corporate
of
an
governance
(control) is limited to some extent as well by the current
REIT legislation precluding five or fewer "individuals" from
owning more than fifty percent of the outstanding shares.
This legislation is currently being challenged in Congress to
allow pension plans to own larger shares of REITs.'
Another advantage which equity REITs can offer taxexempt
investors
is
an exclusion
from
Unrelated
Income Tax for investment in leveraged assets.
Business
Currently,
tax-exempt investors are taxed on any investments in levered
assets.
Ultimately the acceptance of equity REITs as
an
investment choice for institutional investors should improve
the ability of private owners to raise capital.
The Foreign Precedent
A good deal
has been written on securitization
in
foreign countries as a precedent for REIT growth in the U.S.
Real estate securitization is much more prevalent in foreign
countries where non-recourse lending and large tax benefits
1 Foreign pension fund ownership in REITs is not
currently limited by the "five or fewer rule." The original
REIT legislation did not include foreign pension funds as
"individual investors" under the tax code. Instead, foreign
funds are considered to be a group of investors. U.S. pension
funds are considered "individual investors" under the tax law.
25
were not common; the United Kingdom, France, Japan, Hong Kong
and Australia all have large property share markets [22] (See
An example of the extent of securitization in
Figure 5).
foreign markets is that a single public real estate company
in
has
Estate,
Mitsubishi
Japan,
stock
a greater
market
capitalization ($14 billion) than all publicly traded U.S.
REITs ($11.1 billion) (data as of 11/91) [37].
stocks
represent
1.3%
of
the
Japanese
Real estate
market,
stock
as
measured by the Salomon-Russell Broad Market Property Index,
versus 0.3% in the U.S.
The authors imply that based on the
tax law changes and the lack of financing available, the U.S.
value is
REIT market should grow to the point that its
in line
with the global property market.
Conclusion
The
precedent
for
which
securitization
currently
exists in foreign markets and the demand for liquidity in the
marketplace are compelling arguments for the growth of equity
REIT securitization.
involved
taking
in
relatively
However, outside of the valuation issues
private
real
estate
little has been written on the
securitization
in
today's
marketplace.
public,
holdings
impediments
These
to
other
impediments, which include the cost of the transaction, the
psychological
impact of going public, and the size of the
asset base required to name a few, are significant.
The basis
of this thesis is to look at the true costs and benefits of
26
Figure 5
GLOBAL PROPERTY UNIVERSE
As of 12/31/91
Country
Far East
Japan
Hong Kong
Singapore
Malaysia
Australia
Europe
United Kingdom
France
Netherlands
Spain
Germany
Other Europe
North America
United States
Canada
No. of
Companies
Approx.
Cap. ($B)
Total
Market Cap.
% of
Total
31
19
9
7
12
$40.0
26.0
5.4
4.3
3.7
$2,900
99
42
53
170
1.38%
26.26%
12.86%
8.11%
2.18%
78
$79.4
$3,264
2.43%
39
29
8
15
5
28
$14.2
11.6
5.8
3.7
1.7
12.4
$881
319
NA
NA
344
NA
1.61%
3.64%
NA
NA
0.49%
NA
85
$49.4
$2,600
1.90%
103
15
$12.0
4.0
3700
242
0.32%
1.65%
118
$16.0
$3,942
0.41%
Note: To be included in these totals, a firm must be an investment-oriented
equity holder of real estate. Non-U.S. companies with market capitalization
below $70M are not included.
Source: Alex. Brown Kleinwort Benson, GT Global
27
an initial offering for a public equity REIT based on the
insights of leading professionals in the industry.
CHAPTER 3:
THE COSTS AND MARKET DRIVEN REQUIREMENTS FOR AN
EQUITY REIT IPO:
A LEADING UNDERWRITER'S VIEW
On June
12,
1992,
I interviewed
William
Byrnes,
a
Managing Director of the Corporate Finance Division of Alex.
Brown & Sons, Inc.
Alex. Brown is a leading underwriter of
equity REIT offerings in the U.S.
Byrnes has put together a model which outlines the
expenses and desired parameters for initial public offerings
of
equity
Figures 6).
REITs
from
the
underwriter's
perspective
(See
It is evident from the costs and market driven
requirements outlined in the model that an initial
public
offering is a process which few private owners of real estate
can
successfully
prohibitive
undertake.
transaction
specific deal structure.
costs
and parameters
The
costs
and
IPO
the
process
market
involves
requires
a
The following is a discussion of the
outlined
in
the Alex.
Brown
& Son's
model:
OFFERING SPECIFICATIONS:
1.
Minimum Equity Offering - $60 Million:
According
to
requirement of $60
subjective
and
Byrnes,
million
objective
the
minimum
offering
size
is driven by a combination of
criteria.
From
the
subjective
perspective, a minimum offering size is needed to generate
sufficient liquidity for the REIT investors.
If the market
capitalization of a REIT is too small, shareholders will not
enjoy adequate liquidity due to the small size of the
29
Figure 6
IPO REIT Expenses and Offering Parameters
May 14, 1992
Offering
Minimum Equity Offering:
$60 Million
Underwriters Overallotment:
(Green Shoe)
15% (Specified Properties)
Ownership by Principals:
10% +
Underwriters Discount:
7% Range
Offering Expenses':
Printing
SEC & Blue Sky Fees
NYSE Listing
Legal Fees
Accounting Fees
Underwriters Advisory Fee
Appraisal Fees
Total Cost $1 Million
Initial Yield to Investors:
8
-
9%
Initial Dividend Payout Ratio :
80% -
Debt to Equity Ratio:
0 -
Estimated Annual G&A Expense:
$500,000
2
Source:
90%
50%
Alex. Brown & Sons, Inc.
3 The majority of these expenses would be incurred prior
to SEC filing.
Based on Funds from Operations which is operating
income of the properties less interest expense and REIT
operating expenses.
This calculation excludes any capital
gains or non-recurring income.
2
30
tradeable
market.
capitalization
(in
In
addition,
the range of $60MM)
a
is
minimum
market
needed to attract
institutional interest.
An objective determinant of the $60MM offering is that
$60MM is the minimum offering that can be listed on the New
York Stock Exchange.
Not
only does
an NYSE listing add
prestige to the offering, but less underwriting is required
to clear state Blue Sky laws for NYSE registered offerings as
Initial public offerings below $60MM can be listed on
well.
the American or Over the Counter (NASDAQ) exchanges.
All equity REIT IPOs involve substantial pre-offering
expenses
including
the
underwriter's
advisory
fee2 ,
legal
fees, accounting fees, printing fees and appraisal charges
among others.
In addition, an underwriter's discount in the
range of 7% is also charged if the offering is successfully
brought to market.
A minimum
justify these expenses.
economically
involved.
unfeasible
offering size is necessary to
Otherwise, the transaction may become
due
to
the
level
of
hard
costs
Based on the costs and parameters outlined in the
M - Symbol for thousand.
MM -
Symbol for million.
An advisory fee is charged by the underwriter to cover
Private
all of the pre-offering consultation expenses.
entities converting to REITs typically require advisement on
forming a new operating company, structuring the transaction,
and dealing with the partnership roll-up issues. Real estate
offerings are contrasted with typical corporate offerings
which do not require the same level of advisement in most
Kimco Corporation's IPO in November included an
cases.
advisory fee of $600M on a $128MM offering.
2
31
Alex. Brown offering model, a $60MM offering would generate
hard costs of
$5.2MM which constitutes
8.7%
of the total
offering.
In addition, an asset pool of a certain size is needed
to justify the in-house advisory services and management which
the market currently demands.
Self-administered and
self-
managed equity REITs tend to trade at higher market prices
relative to current asset values compared to REITs which have
third party advisors and property management [28].
The market
appears to value the exclusive focus of management and the
lower
cost
which
is
typically
associated
with
in-house
management.
Other industry specialists have discussed different
minimum capitalization requirements for equity REITs ranging
from $50 to $250 million.
Stanford Alexander, President and
C.E.O. of Weingarten Realty Investors, claims that a minimum
market cap. of $200 - $250 million is required for a REIT to
be viable today [8].
This belief is based on the fact that
larger REITs are rated and can attract institutional money
more easily.
Bruce Garrison of Kidder Peabody & Co.,
Inc.
claimed that the size requirements of the marketplace, which
is primarily driven by the needs of institutional investors,
limits the number
of
potential
initial
public
offerings.
REITs that can be formed from large existing pools of real
estate holdings, such as commingled funds managed by advisory
firms, will be favored by institutional investors [8].
2. Underwriters'
Properties):
This
Overallotment
is
a provision
agreement which allows the
(Green Shoe)
- 15% (Specified
included
an
syndicate
in
underwriting
(investment bank) to
purchase additional shares from the offeror at the same price
as the original offering.
In this way, the underwriting group
can cover shares sold short without financial risk.'
Unlike
a
typical
short
greenshoe is a way for the
selling
transaction,
the
investment bank to maintain a
stable market for the new offering in the volatile early days
of trading (30 - 40% of Kimco offering traded the first day).
Typically, new REITs have traded at a discount to the offering
price on the first
trading day.
When the green shoe provision
is exercised, the offeror issues additional shares for the
exclusive purchase of the underwriter.
The underwriter then
purchases the shares to offset selling pressure and stabilize
the share price.
The underwriter's overallotment is limited
by NASD regulation to 15% of the offering.
A greenshoe is
typically used in combination with a naked short which is
another
way
stability.
for
the
investment
bank
to
maintain market
According to Byrnes, "the goal of the investment
bank is to walk away from an offering at a breakeven price (at
the
offering
price).
However,
it
is
typical
for
the
investment banks to lose money even after using the greenshoe
.1 Definition of "Greenshoe" from: Pessin, Alan H.,
Ross, Joseph A., Words of Wall Street, p. 101, Dow JonesIrwin, 1983.
33
and naked short to stabilize
the share
price."
From the
perspective of the offeror, the issuance of additional shares
further
dilutes
existing
equity
holders.
However,
the
dilution is minimal and any stability which can be added to
the share price is beneficial [2].
3. Ownership by Principals -
Potential
investors
10%:
in
equity REITs
ownership for a number of reasons.
substantial
value
insider
First, the market views
ownership by the principles
as
a surety that
management is committed to the future of the REIT.
Second,
insider ownership tends to mitigate conflicts of interest from
the investors' point of view as management is evidencing it's
commitment to enhancing share value.
According to a Merrill
Lynch executive:
Investors are essentially looking for commonality
interests between the operators of the company and
management
focus
undivided
investor
through
management compensation in the form of dividend yield
appreciation through mutual stock ownership of
company.'
Alex.
Brown's ten percent
insider ownership
of
the
and
and
the
requirement
is
based on the percentage of ownership held by principles in the
more successful equity REITs.
The perception in the marketplace is that substantial
insider
ownership
will
benefit
the
share
price,
and
I Berquist, Jack, "It Takes More Than Just Sizzle to
Sell a REIT Today on Wall Street," The Institutional Real
Estate Letter, April 1992, p.13.
34
intuitively this makes sense.
a
REIT
well-established
However, Green Street Advisors,
research
firm,
developed
a
statistically based pricing model in 1989 which attempted to
quantify what factors cause REITs to trade at premiums or
discounts
asset
to current
value.'
The
of
level
insider
ownership was tested as a factor which influenced share price
(among eight other factors), and according to the results, it
offered little explanation of why the discounts to current
asset value exist.
Instead,
and
geographic
management,
factors
property
such as value added
focus,
and
level
of
overhead expenses explained most of the discount or premium.
However, Green Street added that the small sample size may
have
been
responsible
for
the
poor
explanatory
power
of
insider ownership as a determinant of share price [18].
4. Underwriters'
Discount - 7% Range:
An underwriting fee of approximately 7% of the total
equity offering,
underwriter,
is
as determined by the pricing
charged
to
the
offeror
if
set by the
the
issue
is
successfully brought to market.
I The statistical study involved a sample of 19 equity
REITs and attempted to forecast the effects of 9 factors on
The
REIT share price in relation to current asset value.
model explained 65% of the variations that are actually seen
in current value discounts. The level of insider ownership
was one of the factors included and was found to be
statistically insignificant by the model. Insider ownership
ranged from a high of 25.5% to 0.1% in the companies surveyed.
35
5. Offering Expenses -
$1 million:
Offering expenses include printing charges, SEC & Blue
fees, accounting fees,
legal
Sky fees, NYSE listing fees,
The $1 million
underwriter's advisory fee and appraisal fees.
fee is based on a sample offering size of $60 million in
The majority of these fees constitute pre-offering
equity.
expenses which will be incurred whether or not the offering
comes to market.
advisory
fee
The possible exception is the underwriter's
which
may
be
contingent
a
upon
successful
offering, however, some minimum fee will be charged by the
underwriter in any case to cover costs.
Typical equity REIT IPO's require updated appraisals
on all of the properties which will be included in the REIT.
This
is
necessary to
establish
current asset
In
value.
addition, three years of audits by a "Big Six" accounting firm
are required for all of the properties going into the REIT as
well
as for
substantial
partnerships
the parent company
as well,
are
especially
being
[2].
if
rolled-up
partnership for REIT formation.
Legal
a number
into
a
fees will
be
of individual
master
limited
Under the Alex. Brown model,
the law firm chosen by the private owner will be subject to
the underwriter's approval.
5. Initial Yield to Investors - 8.0% to 9.0%:
The market is currently demanding a dividend yield in
the range of eight to nine percent for new equity REITs.
36
This
yield has been derived based on the typical yield provided by
equity REITs in the current market plus a small risk premium
in the range of 50 to 100 basis points for a new issue.
New
issues tend to be priced at a slightly higher yield primarily
because they do not have track records as public companies
[8].
REIT dividends are paid out of Funds from Operations
which is the industry benchmark for evaluating a REIT's cash
flow.'
Typical dividend payout ratios of equity REITs are in
the range of 80 to 95% of Funds from Operations.
Specific REITs which are going public will likely be
priced at a small yield premium to the existing REITs in their
peer group.
For example, the initial public offering of Kimco
Corporation was priced at yield of 8.8% based on the current
yield of similar regional shopping center REITs plus a small
risk
premium
[8].
Milton
Cooper,
Chairman
of
Kimco
Corporation, stated that their initial yield was targeted in
a range from 7.8% to 8.8%
and that Kimco came out at the
higher end of that range due to a one hundred point drop in
the stock market the week before the offering [8].
The yield
demanded in the
market today for a new
equity REIT offering may present a significant impediment to
the private real estate owner.
However, as the chart on the
following page shows (Figure 7), there is a wide range in the
I Funds from Operations is defined as net operating
income from the properties less interest expense and REIT
operating expenses.
This calculation excludes any capital
gains or non-recurring income [5].
37
discount to property value offered by the public market based
on
the
pricing
of
the
For
offering.
conservatively priced dividend yield of 9%,
at
example,
a
and a conservative
dividend payout ratio of 80%, the market based discount to
appraised value will be in the range of 22% (See Restrictive
However with a less restrictive
Pricing Scenario Figure 7).
offering structure priced at a yield of 8.0% and a dividend
payout ratio of 90%, the market discount to value is only
(See
1.68%
Open
Scenario
Figure
discount to current appraised value
reasonable
A more
7).
is between these
two
extremes in the range of 12-15% (See Moderate Pricing Scenario
Figure 7).
Based on these results,
it appears that the
lower
valuation offered by the stock market is primarily associated
with the 50 - 100 basis point risk premium for a new offering
and
the
capitalized
value
of
the
incremental
associated with running a public company.
expenses
For example,
if
the
Moderate Pricing Scenario is used, a 75 basis point reduction
in the yield and the addition back of the capitalized value
of
the
operating
expenses
(at
the
new
yield
of
7.75%),
explains 107% of the valuation reduction offered by the public
market.
Assuming that the risk premium associated with new
companies dissipates over time, one may look to the value of
the incremental expenses associated with being public as the
primary reason for the valuation discount offered by the stock
market.
Figure 7. IPO Equity REIT Property Valuation Discount
Restrictive
Pricing
Appraisal Based Valuation
Open
Pricing
I
9.20%
9.20%
NREI Cap. Rate for Los Angeles Retail (1)
Moderate
Pricing
9.20%
$10,000,000
$10000,000
$10,000,000
$108,695,652
$108,695,652
$108,695,652
Assume: Property Net Operating Income
NREI Property Value
(NOtCap. Rate)
I'
IPO Equity REIT Valuation
Properties NOI
Less: REIT Operating Expenses (2)
Funds from Operations (3)
Dividend Payout Ratio
Dividend
$10,000,000
(500,000)
$10,000,000
(500,000)
$10,000,000
(500,000)
$9,500,000
$9,500,000
$9,500,000
80.00%
90. 00%
85.00%
$7,600,000
$8,550,000
$8,075,000
9.00%
Required Investor Yield
Market Based Property Value
(Dividend/Yield)
8.00%
$84,444,444 1 $106,875,000
8.50%
$95,000,000
Stock Market Based Discount to Value
22.31%
1.68%
12.60%
Stock Market Indicated Cap. Rate
11.84%
9.36%
10.53%
(1) National Real Estate Index capitalization rate for Los Angeles
based on real estate transactions completed fourth quarter 1991.
(2) Assume that property NOI already includes management expenses at
4% of NOI. An additional 5% in expenses has been added for
incremental REIT costs such as public relations and annual
investment banking fees. The combined expenses are in line with
industry averages.
(3) Assuming there is no debt on the properties.
39
In addition, the valuation discount offered by the
stock market may be partially attributable to the different
valuation methods used by appraisers and the public markets.
The stock market values an income stream based on the property
market today
stream.
and
the
expected volatility
of
income
that
Unlike an appraisal based value, there is no lag in
the valuation due to the timing of comparable transactions,
nor is there the associated smoothing which has been welldocumented in appraisal based performance data.
In addition,
because of its orientation to cash flow and the open-ended
nature of equity REIT holdings, the stock market tends to
attribute negligible value to the property residuals.
Although the market's valuation of REIT holdings may
be
considered
restrictive
by
some
private
owners,
Bruce
Garrison, the head of real estate research for Kidder Peabody,
stated:
The REIT vehicle provides a pricing mechanism for real
estate which I believe is superb. It's instantaneous,
it comes from a variety of sources and it's not
inherently biased by one party in the appraisal process.
As a result, I've always espoused the view that one of
the beauties of REITs is offering the world an
alternative pricing mechanism for real estate.'
However,
no matter how efficient the capital market's pricing
of real estate may be, it still may represent an impediment
to private owners in a restrictively priced market.
I
Coopers & Lybrand, REITs the Future
Perspectives of Industry Experts, 1992, pp. 94-95.
40
is
Now,
6. Initial Payout Ratio -
80% to 90%:
The initial payout ratio refers to the percentage of
Funds
from Operations which is paid out
in dividends.
A
payout ratio in the range of 80% to 90% indicates that there
is a 10% to 20% cushion in the cash flow of the REIT.
In
other words, Funds from Operations could decline by up to 20%
and the REIT would still
be able to meet its
dividend payment.
The market values a cushion in the cash flow of REITs and
historically REITs with more conservative dividend payout
ratios have traded at higher earnings multiples
[8].
The
reasoning behind the higher share price is that by having a
conservative payout ratio, the REIT is retaining earnings and
can invest those earnings at a higher rate than shareholders
receiving dividends [8].
Although retaining a percentage of
cash
flow does
provide a cushion to investors, it also reduces the dividend
payment initially which effectively reduces the offering price
to the private owners.
This restriction of cash flow may
appear to be an impediment to new offerings, however, if the
private owners maintain a substantial ownership position a
conservative cash flow will be rewarded with a higher share
price.
7. Debt to Equity Ratio -
0% to 50%:
The market today tends to view leverage as a source of
risk.
This view is based on the current problems in the
commercial real estate market which have been caused in part
by the excessive use of leverage.
It follows then that the
publicly traded equity REITs which are trading at the highend of the spectrum today carry leverage well under 50% [28].
For example, Washington REIT was trading at a dividend yield
below 5% at 2/18/91 and had a debt to total capitalization
ratio of
2.6%.
New Plan Realty also trades at a dividend
yield in the 5% range and has debt of only $15 million on a
market cap. of over $1 billion [28].
The downside of the market requiring low leverage for
new equity REITs
is that
equity
is
source of funding in today's market.
a much more
expensive
If an equity REIT could
carry debt below it's cost of equity at up to 70% of market
value, for example, the returns to the shareholders would be
improved
and
the
offering
price
would
be
(I
higher
am
assuming that a debt to equity ratio in the range of 65-70%
would not create a prohibitive cost of capital).
Although I
am not an advocate of leverage and the risks it entails, it
is possible that the stock market
with debt to equity
pointed out,
in
excess of
"the better stories
is too critical of REITs
1:1.
from a
As Bruce
Garrison
stock point of view
are those that encompass the judicious use of leverage because
you can get better returns if done right."'
Coopers
& Lybrand,
REITs
the
Future
Perspectives of Industry Experts, 1992, p. 97.
1
42
is
Now,
Expense - $500,000:
8. Estimated Annual G&A
The market requires that the operating expenses of
REITs
are maintained
within
a certain
range.
Excessive
management expenses will result in a devaluation of the share
price
as
the
REIT
shareholders.
is
The
not
maximizing
$500,000
the
estimate
return
for
to
general
the
and
administrative expenses is based on an offering in the $60
million
range.
A more
general
guideline
for
operating
expenses is that they should constitute approximately 0.6% of
assets (stock market value) or 9% of Funds from Operations
[19].
These expense guidelines are
based on the
average
expenses of the Garrison Brothers Index of twenty publicly
traded equity REITs.
Private owners who convert their holdings into equity
REITs
typically
have
reduce
to
operating
significantly to meet REIT industry standards.
expenses
Many owners
actually see this expense reduction as a positive because the
companies involved are forced to maximize their profitability.
As Milton Cooper of Kimco Corporation stated:
The discipline required of a publicly traded REIT has a
People trusted us with their money;
positive aspect.
also a responsibility. For
an opportunity it's
while it's
instance, we found that as good as we might have been
before, we got much tougher with respect to expense
control because we were dealing with other people's
money.'
Although expense reduction can be looked at as a positive for
Coopers & Lybrand, REITs: The Future
Perspectives of Industry Experts, 1992, p. 17.
43
is
Now,
private owners converting to REIT ownership, implementing the
expense controls and downsizing the organizations are other
hurdles which must be overcome.
A sophisticated management
team is needed to bring expenses in line with the industry and
control expenses once the REIT has been formed.
Sample REIT Offering (See Figure 8 next page)
Based on a sample offering size of $94 million, the
offering costs associated with an equity REIT IPO, as outlined
by Alex. Brown and Sons, Inc., would involve an incremental
cost of capital of 1.49% over the market dictated return on
equity.
In my offering example, outlined on the following
page, if the market required a total return of 17% (dividend
yield + appreciation),
would
be
18.49%.
the total cost of capital to the issuer
Based
on
this
example,
the
expenses
associated with the offering should not be prohibitive at only
1.49% of the total offering.
Figure 8. Sample REIT Offering
Assume: Funds from Operations
$10,000,000
85% Payout Ratio
$8,500,000
Offering Value @ 9% Yield
$94,444,444
Less: Underwriter's Discount @ 7%
Offering Expenses
($6,611,111)
($1,000,000)
Total Offering Proceeds to Issuer
$86,833,333
Assume: Less Stock to be held by
Principals @ 10%
($8,683,333)
Cash Proceeds to Issuer (1)(2)
$78,150,000
Assume 10 Million Shares Issued:
Offering Share Price
Offering Proceeds per Share
Cash Proceeds per Share
$9.44
$8.68
$7.82
Assume Market Required R.O.E:
17.00%
Required Total Return per Share
$1.61
Cost of Capital to Issuer
18.49%
Incremental Cost of Capital to Issuer
1.49%
(1) Assumes there is no debt on the properties.
(2) Worksheet based on Alex. Brown & Sons, Inc.
offering model.
45
OTHER MARKET DRIVEN ISSUES
& CONVERSION TIMETABLE:
In addition to the market driven requirements for the
actual offering, the market also prefers certain underlying
The
structures.
ownership
and
characteristics
property
following is a discussion of the issues which Alex. Brown &
Sons, Inc. includes in its specifications for a successful
equity REIT:
1. Fully Specified Offering:
In today's marketplace, investors and analysts prefer
to
see
existing
an
pool
of
properties
specified
5
(ie:
regional malls in St. Louis) rolled into REIT ownership rather
than a "blind pool".
The term "blind pool" refers to raising
a pool of capital in advance of acquiring properties.
The
investments
will
investors
are
"blind"
as
to
what
those
eventually be and are putting all of their faith in REIT
management.
The market's distaste for blind pools stems from the
historically poor performance of blind pools in the 1970's.
During the 70's, there was a feeding frenzy on wall street for
REITs and hundreds of millions of dollars flowed into blind
pools
in
the
form
of
both
mortgage
and
equity
REITs.
Underwriting quality for investments was often poor with some
inexperienced managers placing money.
In addition, there was
just too much money flowing into real estate at the same time
[15].
46
The overwhelming attitude on wall street today is that
a blind pool cannot be raised.
However, a $165 million blind
pool mortgage REIT was offered just recently (July 1992) by
Allied Capital Commercial Corporation.
It appears that blind
pools may be acceptable based on the expected total return of
the offering and the management team involved.
Another interesting point is that once an equity REIT
is
established, it
is able to raise additional equity without
specifying what the equity will be invested in.
Essentially,
the market has enough comfort with existing REIT management
to
allow
capital
to
be
raised
for
"blind"
investments.
Perhaps the market will allow more proven management teams to
raise blind pools of capital for equity REIT offerings in the
future.
2.Preferred Property Type - Retail or Apartment:
Presently, retail properties and apartment properties
are the desired asset classes for new REITs.
is
based
on
analysis
that
these
two
asset
This attitude
classes
will
outperform the commercial office and industrial markets over
the next few years.
According to Alex. Brown & Sons, Inc. May
1992 Real Estate Stocks Monitor, apartments are expected to
be the first property type to show improvement coming out of
the recession primarily due to the significant decline in
multi-family housing starts since 1986 [12].
have added
Other analysts
that the production of new multi-family
47
units
reached a ten year low in 1990 and the level of new starts was
down over 40% in 1991 [19].
In addition, apartment vacancy
rates, currently in the range of 10%, are expected to decline
with the depressed level of construction and pent-up demand
building for all forms of shelter [19].
Retail forecasts are driven by the retail sales on the
demand side and new construction on the supply side.
other
real
estate
asset
classes,
retail
Like all
construction
has
dropped off to a virtual standstill in the past two years.
With little new construction
and the continuation of
the
current credit squeeze, analysts are hoping that a rebound in
the national economy will spark consumer confidence and thus
retail sales.
Increased retail sales volume will bring down
vacancy rates and lead to higher rents in the sector.
One
analyst indicated that his focus on retail was driven by the
redevelopment opportunities available in the market as well.
Existing assets can be purchased cheaply and repositioned in
the market [19].
While the benefits of retail and apartments over other
asset classes make sense on a national level, local markets
may vary substantially.
For example, the office market may
be stronger than retail in certain cities or an owner may have
a
local
product
niche
(such
as
A+
office)
which
has
consistently performed with less volatility than the broader
market.
It is my contention that the property holdings of
potential equity REITs should be reviewed based on historical
performance and the underlying local real estate market more
than national trends.
3. Geographic Concentration:
Investors and market analysts are most receptive today
geographic
The
area.
focused both by product type and
are
to new REITs which
market
looking
is
for
focused
a
management team which is very good at operating and acquiring
This reasoning is
a specific product in a geographic region.
is
based on the idea that real estate
inherently a local
business and that local knowledge and expertise can provide
above market returns.
Opponents
of
this
strategy
believe
that
focus
by
property type and geographic area opens up REITs to specific
risks
associated
with
a
region
or
asset
institutional players have noted that
class.
Some
equity REITs should
apply modern portfolio theory and diversify by product type
and region to provide market returns with
[26].
However,
less volatility
the risk diversification achieved through the
application of modern portfolio theory may be offset by the
risk of operating in unfamiliar markets.
4.No Conflict of Interest Issues:
In order to avoid conflicts of interest between REIT
management and shareholders, the market prefers new equity
REITs with a certain structure.
First, the market wants all
of the real estate activity of the principals to be associated
with
the
splitting
operating
For
REIT.
its
example,
time between
company.
management
should
not
be
the REIT and another separate
Second,
the
administered and self-managed REITs.
market
prefers
self-
Again, this preference
is based on the idea that shareholders interests are better
protected when the REIT ownership is actively involved in the
operation of the REIT and management of the properties. Selfadministered REITs tend to trade at higher premiums to book
value than their externally advised counterparts [28].
Finally, the market wants the REIT to have a 100% interest in
the properties.
If multiple partnerships are converting to
a REIT, the partnerships should be rolled up into a master and
the REIT should take over the general partner position with
100% ownership in the underlying properties.
The market does
not want a situation where the REIT does not have full control
over the properties.
The much publicized failure of the
Taubman Cos. equity REIT offering in June was partially due
to conflict of interest issues.
As the deal was structured,
the Taubman REIT would not hold a general partnership position
in all of the properties and that lack of control was not
acceptable to the market.
On the issue of self-advised and self-managed REITs,
the market may be mistaken in making a blanket judgement of
REITs
which
advisors.
If
have
third
party
a REIT can lower its
property
managers
and/or
expenses by contracting out
for these services, or if the third party managers are more
qualified than the management of the REIT, the REIT should be
rewarded
for
being
externally
advisory
and
management
advised
capabilities
of
managed.
The
individual
REITs
or
should be looked at on a case by case basis.
5. No Ground Leases:
Underwriters are not accepting ground leases as assets
which
can
be
converted
to
REIT
The
holdings.
market
perspective is that a ground lease does not provide the same
level of control as outright fee simple ownership.
This is
based on the premise that a ground lease constitutes ownership
of an income stream for a defined period of time only and not
the underlying property.
Conversion Timetable:
A typical equity REIT offering will take in the range
of 26 to 40 weeks to complete, according to Alex. Brown &
Sons, Inc.
The majority of this time will be spent on the
pre-offering due diligence and structuring the transaction.
If a partnership roll-up is necessary, a great deal of time
will be spent working through the partnership and legal issues
[1].
All inclusive, the due diligence and deal structuring
phase of the conversion should take 16 to 26 weeks.
10-14
weeks
will
be
spent
on
the
actual
The final
offering which
includes drafting the documents and allowing for SEC review
and marketing.
From the offeror's perspective, the time that must be
Not
dedicated to the REIT conversion is a large impediment.
in real
only are the costs of the transaction substantial
dollars, but there is a huge opportunity cost involved in the
conversion as well [2].
his
of
underlying
The offeror has to shift focus off
business
up
for
to
ten
and
months
This is time which could
concentrate on the REIT conversion.
be spent on pursuing other forms of restructuring or focusing
on bringing in new business.
In addition, both the capital
and time invested is all at risk because there is no assurance
that the transaction will ever make it to market [2].
Additional Points from Interview with William Byrnes:
1.
View on Growth in the Equity REIT Industry
By the late 1990's, REITs will emerge as the dominant real
estate (financial) structure.
REITs provide both liquidity
In the
and the opportunity to diversify real estate holdings.
future, growth in the industry will be spurred by pension fund
Directors
investment.
of
institutions
(pension
funds,
insurance companies and advisory firms) are currently involved
with
cleaning
up their
problems.
Once
that
process
is
finished, institutionally owned properties will be converted
into
REITs
and
the
tax-exempt
investors
will
consideration to REITS as an investment vehicle.
pay
more
Two Biggest Impediments to Securitization at Present
2.
1.
Partnership tax issues (See Chapt. 4, part 2).
2.
Valuation/Conceptualization - It
is hard to swallow the
valuation offered by the stock market.
At the partnership level, many private developers have to
struggle with the tax issues associated with the individual
partners and with bringing all of the individual partners from
different properties together.
At present, the master limited
There needs to
partnership structure presents some problems.
be a way to shelter the tax
liability of
the
individual
partners when they exchange their master limited partnership
interests for REIT shares.
3.
The Success of the Kimco Corporation Offering
Kimco
is a good case
offering
was
study of
successful
an equity REIT IPO.
primarily -due to
the
The
following
reasons:
1. The properties were valued at a cap rate of 10 -12%.
2. Initial yield to investor of 8.8%.
3.
No
conflicts
of
interest
-
Aligned
owner's
and
investor's interest.
4. Individual partnerships were successfully rolled-up.
4.
Stock Market Valuation of Real Estate
In the short term, the market will discount the value of the
real estate holdings.
However, in the long run values should
The
improve as the market rewards successful management.
public markets pay a premium for
a good management team.
Examples of the premium which the market will pay for strong
management
include Kimco Corporation
and Washington REIT.
Kimco was originally offered at $20 per share and has now
moved
up
to
$26
share
per
largely
a result
as
of
the
confidence which the market has in Kimco's management.
Washington REIT is currently trading at an effective cap. rate
of 4-5%, however, the properties aren't worth that much.
The
market is rewarding Washington REIT for its solid management
and is paying a premium for it.
5.
Primary Benefit of Converting to a REIT in Today's Market
In addition to the liquidity associated with the REIT vehicle,
REITs today have the ability to raise additional
capital.
Currently there is
a positive yield spread in the marketplace
between
REIT
equity
capitalization rates
dividend
available to
yields
and
property
established REITS
(cap.
rates in the range of 12-15%).
Examples are Federal Realty
with a current
in
dividend yield
the
range
of
7.5%
and
Washington REIT with a current dividend yield in the range of
5.2%.
In this type of yield environment, REITs will be able
to grow
current
income which will
result
in
share
price
appreciation.
However, the true cost of capital for equity REITs
(Return on Equity: dividend yield + appreciation) is close to
or above property all-in equity yield rates from net operating
income and price changes.
To maximize wealth to existing
shareholders, REITs would be better served by the judicious
use of leverage.
For example, if debt could be raised in
today's market at a cost of 7% (prime + 1%),
and a property
could be acquired at a cap. rate of 12%, that spread would be
passed on to shareholders without the dilution associated with
raising additional equity
(This is
assuming that leverage
would not rise to the point at which it would significantly
increase the cost of capital to the firm).
55
Figure 9.
Summary of IPO REIT ISSUES
Additional Specifications for a Successful Offering
-
Fully Specified Offering
-
Preferred Property Type: Retail or Apartment
-
Geographic Concentration
No Conflict of Interest Issues:
-
-
-
All Real Estate and Real Estate Activity of Owners
Must Be Handled Through REIT
-
Self-Administered
Self-Managed
-
100% Interest in Properties (Partnerships Must be
Rolled Up)
No Ground Leases
List on NYSE
Accounting by "Big Six" Firm
Law Firm Subject to Underwriter Approval
Conversion Timing
16 -
Due Diligence and Structuring Phase:
26 Weeks
-
Creation & Analysis of Historical Operating Performance
Projections & Creation of Business Plan
-
Agreement on Properties
Creation of Company
-
Article of Incorporation, By-Laws
-
Selection of Directors
-
Resolution of Conflict of Interest Issues
-
Tax Issues
Partnership Roll-Up Issues
Appraisals
-
(3
Audits
required)
years
of
historical
information
property
Offering Phase:
10 -
-
--------------
Drafting Document
SEC Review and Marketing
26 -
Total
Source:
Alex. Brown & Sons, Inc.
14 Weeks
40 Weeks
OTHER PERSPECTIVES ON THE INITIAL PUBLIC OFFERING
PROCESS AND THE EQUITY REIT INDUSTRY
CHAPTER 4:
Part One
The Private Developer Engaged in the Offering Process
On
June
11,
1992,
interviewed
I
a
Senior
Vice
President and the Chairman of Development Company X' which is
currently working through the initial
public offering process
Our conversation focused on the costs and
for an equity REIT.
benefits of taking private holdings public from the offeror's
The following is a distilled version of our
perspective.
conversation:
Costs of the Transaction:
1.
Underwriting Fee
A 6.5%
fee is charged on the sale of the securities.
additional $500,000 feasibility fee is
successfully brought to market.
charged if
An
the REIT is
If the transaction does not
go through, the investment bank receives a flat kick-out fee
of $250,000 to cover their costs.
2.
Legal Fees
Substantial
legal
fees
are
involved
in
structuring
the
transaction and working through the roll-up of the individual
I The name of the development company must be kept
confidential while the company is working through the offering
process.
partnerships into a master limited partnership.
A myriad of
different interests are involved and must be represented.
3.
Accounting Fees
years
Three
by
audits
of
a
6" accounting
"Big
are
firm
required for all holdings being put into the REIT and for the
parent development company.
4.
Opportunity Cost
There is an opportunity cost involved with not being able to
carry
on
normal
business.
Potential
income
generating
transactions must be passed up to concentrate on the REIT IPO.
Excluding the underwriter's 6.5% discount on the sale of the
securities, the offering costs will total $2 - 4 million plus
the
opportunity
addition,
during
the
with
associated
cost
underwriting
period,
In
business.
lost
the
bearing the entire risk of the transaction.
offeror
is
No one will
warrant that the transaction will go through.
The Partnership Conversion Process:
Trying
to
pull
all
of
the
limited
partners
from
different properties in one direction is an incredible task.
The partners need to be educated about the REIT conversion
process and convinced that the transaction makes sense and
that their rights will be protected.
Psychologically, the
partners have to get comfortable with the transaction as well.
Some of the investors have been involved with the development
company for a great number of years.
There is a fear on their
part that going public will diminish the relationship and
reduce the level of service which they are receiving.
The
developer's job is to allay their fears and work to protect
their interests.
In this particular offering, the REIT will purchase a
general partnership position in the master limited partnership
which will
effectively dilute
the
equity
interest of the
partners (the new equity will be replacing outstanding debt).
At that point, the value of one diluted share in the master
limited partnership will be equal to one share of REIT stock.
The income distributions will be the same for partners and
REIT
shareholders,
as
will
any
property
appreciation
or
depreciation.
If
a limited partner wants liquidity, he must exchange
his- partnership
interest
for
shares
exchange constitutes a taxable event.
in
the
REIT.
This
For partners with a
very low or negative property basis this exchange creates an
enormous tax liability.
Converted shares are not taxed based
on their diluted ownership value, but rather on their original
cost basis.
Limited partners end up receiving a diluted
income stream yet their tax liability is not diluted.
Once
a master limited partnership share is converted to a REIT
share, and the tax liability is paid, the investor's basis
59
steps up.
This tax liability for the limited partners is one of
the biggest barriers for a private company forming a REIT.
First, it is difficult to persuade the partners that the tax
liability
is
by
offset
their
greater
relationships with.
people that we
are
investors
"these
the
Second, according to the
potential for future appreciation.
Chairman,
and
liquidity
have
built
It is in our interest to protect the
rights of these partners to the fullest extent possible."
(Although
the
developer's
interest
in
protecting
their
relationships with partners may imply that forming a REIT is
a short term strategy (ie: Look to the partners to invest in
future deals),
I
believe that the developer's
driven more by a sense of responsibility.
efforts
are
According to the
Chairman, many of these partners literally helped to build
the business.)
Other Impediments to Going Public:
1.
Quality of Life
Taking a private firm public adds needed discipline, however,
confidentiality
private
and
ownership
associated with
many of
are
the
the
lost.
REIT
freedoms
All
vehicle
in
in
associated with
all,
the
the
benefits
current
market
outweigh the costs, so one is willing to sacrifice some of
the luxuries associated with private ownership.
60
2.
Loss of Control
Not only is control lost just by going public, there is the
ultimate risk of being taken over through the public market.
That risk is not there for a private company.1
3.
Valuation
Although the valuation issue is a big one
(REITS demand a
higher yield which equates to lower values), it may be more
perception than anything.
It
should
appears that values
rebound somewhat once the IPO has gone through and the market
gets comfortable with management and its track record.
Benefits of Going Public:
1.
Risk Mitigation
Overwhelming sentiment is that forming a REIT is the best way
to deal with risk in today's market.
It's an effective way
to deal with the debt and equity risk associated with private
development.
In effect, control is traded for liquidity and
risk mitigation.
Personal risk is escaped as well. It
is hard
to avoid personal risk with direct ownership.
1 Historically, public REITs have protected themselves
from hostile takeovers by adopting "poison pills", also known
as rights plans, which can significantly dilute the ownership
Poison pills are activated
positions of potential bidders.
by an unsolicited takeover bid and effectively allow
shareholders to increase their ownership in the firm by
purchasing shares at a substantial discount.
Poison pill
securities are typically adopted without shareholder approval.
Studies have shown that REITs with poison pill protection have
traded at lower prices than their unprotected counterparts
[38].
2.
Expense Control
Going through the process
(of conversion
from private to
public) makes a company really focus on operating expenses.
While it's a gut wrenching process, it's beneficial to have
the company lean and running efficiently.
3.
Access to the Capital & Competitive Advantage
In addition to gaining access to capital and liquidity in a
market with little
conventional credit flowing, forming a REIT
should provide a competitive advantage in the local market.
Few competitors will have the same access to capital while we
will have the ability to grow our portfolio.
[NOTE:
A
critical
determination
for
any
potential
offeror is to analyze their all in cost of capital.
REIT
Based on
the Alex. Brown offering model, the all in cost of capital to
an offeror today would fall
potential offerors
in the range of 15-20%.
should consider whether
less
capital is available through the private markets.
All
expensive
The current
cost of capital for RTC pools is in the range of 25-30%, so
it would appear that owners of better performing properties
should be able to access capital at a lower cost.]
62
Part Two
The Legal Perspective
On July 8, 1992, I interviewed William B. King, Esq.
of Goodwin Procter & Hoar.
Mr. King is one of the leading
real estate investment trust
lawyers in
the nation.
Our
conversation focused on the challenges and issues involved in
converting individual partnerships into a REIT.
The following
is a summarized version of our conversation:
Main Barriers to REIT Conversion:
There
are
essentially
three
major
issues
facing
private owners who are working through the REIT conversion
process.
The first issue is simply persuading the partners
to enter
into the transaction.
The
partners need to be
convinced that their interests will be better served through
REIT ownership than through the individual partnership format.
Oftentimes partners will resist entering into the transaction
simply because they don't fully understand it.
Partners need
to be educated about REITs and the benefits associated with
REIT ownership.
Another sticking point for new offerings has been the
negative publicity surrounding
partnership roll-ups.
The
majority of roll-ups which occurred during the 1980's received
unfavorable media coverage and suffered equally unfavorable
economic results [6].
The criticism of roll-ups was focused
63
on the diminution of limited partner equity due to excessive
fees to the general partner and poor valuation methods [6].
However, with the publicity surrounding roll-ups today, and
the recent SEC regulations, roll-up issues should not be as
much of a problem.
A second impediment to REIT conversion which relates
to the partnership issue is the new regulatory environment
The SEC has already put
surrounding partnership roll-ups.
regulations in place which require roll-up sponsors to provide
more disclosure concerning the impacts on valuation of a rollup and potential conflicts of interest.
In addition, the new
SEC regulations require the general partners to provide at
for
days
sixty
least
approve
to
partners
limited
restructurings .
Congress is also taking a hard look at roll-ups and
legislation is currently under discussion in the Senate which
who
partners
sponsors
roll-up
would require
vote
limited
partners
interest
prior
to
against
would
the
the
roll-up
independent appraisal [17].
transaction.
the
have
compensate
to
right
taking
any
limited
Effectively,
to
cash
place
in
based
their
on
an
According to King, Congress is
basically "bolting the barn door after the horses are out."
The
SEC
protecting
regulations
partners'
have
already
rights.
If
gone
the
a
new
long
way
in
congressional
legislation goes through it will make the whole process too
tedious and will kill alot of transactions.
The
third,
and
impediment
biggest,
to
converting
partnership interests into REIT ownership is the potential tax
liability of the individual partners.
a low or negative basis
If the partners have
in the property, there will be a
significant tax liability due upon REIT conversion.
investors who
were planning
on
holding these
To any
investments
indefinitely, the conversion tax liability is not acceptable.
However, there are certain tax planning strategies to work
around the conversion tax issues.
Three
Different
Partnerships:
Approaches
to
REIT
Conversion
for
Structuring the REIT conversion to minimize partner
tax
liability
is
the
most
costly
and
time
consuming
undertaking from the legal perspective, and may serve as a
major impediment to REIT conversion.
The following are three
different approaches to structuring the transaction according
to Mr. King:
1.
Individual Partnerships
In the case of an individual partnership converting to a REIT
it is a fairly simple process.
Under section 351E of the tax
code, the conversion of an individual partnership into a REIT
is
not
considered
a
taxable
event
because
(investors) do not gain any diversification.
be due upon the sale of the REIT shares.
the
owners
Tax would only
However, if more
than one partnership is involved in the conversion, through
65
a roll-up
for
taxable event.
responsible
for
example,
the
conversion
will
constitute
a
In this case, the individual partners will be
taxable
gains
on
the
exchange
of
their
partnership interest into REIT shares.
The straightforward process of paying tax on gains
realized in the REIT conversion is not the worst alternative
according to King.
It is beneficial for the partners to put
the tax liability behind them and step up their basis in the
newly formed REIT.
However, it is typical for underwriters
to restrict the sale of insider stock in a newly formed REIT
Partners would want the transaction
for a year or two.
structured so that they could at least sell enough REIT shares
to cover their conversion tax liability.
2.
Multiple Partnerships - Delay REIT Status Election
Another approach to
the conversion process, when multiple
partnerships are involved, is
to
consolidate
their
for the individual partnerships
interests
into
a
master
limited
partnership (MLP) two years prior to electing REIT status.
Under this scenario, the MLP will have satisfied the necessary
preference period, and will constitute a single partnership
upon election of REIT status.
The individual partners would
not recognize a taxable gain until REIT shares were sold.
3.
Multiple Partnerships - Immediate Conversion
A
final
strategy
involves
66
rolling-up
the
individual
into
partnerships
a
master
limited
partnership
simultaneously forming a REIT as a separate entity.
and
Once
capital has been raised in the marketplace, the REIT will
purchase a majority position in the MLP.
In most cases, the
equity raised by the REIT will replace existing debt in the
MLP.
Under this scenario, one share of ownership in the MLP
would be of equivalent value to one share in the REIT, and
partners
would
However,
indefinitely.
income
receive
and
appreciation
benefits
to gain liquidity (ie: sell a portion
of their interest), partners would have to exchange their MLP
That exchange would constitute a
interest for REIT shares.
taxable event.
[Final Note:
According
to
King,
the
process
of
simply
exchanging partnership interests for REIT shares is the least
complicated
approach
from
a
legal
perspective.
His
recommendation would be for the partners to simply convert
their interest to REIT shares and pay the tax.
At that point,
the partners have liquidity and no looming tax obligations.
From the offerors perspective, this is the least complicated
and costly route to follow as well.]
67
Part Three
The Independent REIT Advisor
On June 15, 1992, I interviewed Thomas E. Robinson,
Our
Director of REIT Advisory Services for Coopers & Lybrand.
conversation focused on the barriers facing potential IPOs in
today's marketplace as well as the changes needed for industry
The
growth.
following
is
a
version
distilled
of
our
conversation:
Biggest Barriers to REIT Formation:
There are numerous barriers to equity REIT formation
in the marketplace today.
dollar costs
These barriers include the hard
associated with the transaction
such as
the
underwriting fees, legal fees, audit costs and local transfer
taxes
to
a few,
name
barriers.
For
as
example,
well
the
as
other
valuation
less
perceptible
discount
which
is
typically involved with taking private holdings public into
a REIT can be substantial.
Typically, a 200 basis point
premium will be added to the cap. rate on the privately held
properties.
So for example, if a private property is valued
at a cap. of 10%, the public market will probably value that
same property at a cap. in the range of 12%.
not
want
portfolios.
to
take
those
kind
of
Many owners do
write-downs
on
their
(The valuation model in Chapter 3 presented a
typical increase of 130 basis points to the cap rate)
68
Another less perceived barrier associated with equity
REIT formation is the psychological effect of taking private
This is a difficult transition for many
holdings public.
private companies.
Many of the
associated with
freedoms
private ownership are lost once you are reporting to equity
analysts and are under the scrutiny of the public marketplace.
The critical mass needed to bring a public equity REIT
to
market
today
is
substantial
as
In
well.
Robinson's
opinion, you need assets of at least $100 million to justify
the costs of the transaction and to attract institutional
investors.
Finally, the partnership
issues involved with REIT
The focus is
conversions are a major sticking point today.
really on sheltering the tax liability of
partners.
pay
Partners with a low or negative basis will have to
the piper
structuring the
proven.
the individual
upon REIT
conversion
unless
conversion to avoid the
a new way of
tax
liability
is
It will be very interesting to see if the new master
limited partnership format, which several potential offerors
are working on today, will succeed.
Changes Needed for REIT Industry Growth:
In order for the industry to grow substantially, some
changes will be needed.
real estate.
A key issue right now is
We need more of
an
how to value
institutional trading
philosophy in the REIT industry in which the public market
69
gives
In addition,
value to the property residual.
some
private property owners and the public markets need to come
closer together on what the real
estate
is worth
to get
transactions moving.
Another issue facing REITs today is the discount which
the market is applying to externally advised REITs.
There
needs to be a way to structure external REIT management so
that the market's interests will be protected.
effective
for
management,
REITs
and
under
until
the
a
certain
market
size
accepts
isn't
It
to
cost
internalize
some
external
advisory structure those REITs will not be formed.
Institutional investment will also be needed for the
industry to grow substantially.
equity
mutual
investment.
fund
investors
The industry needs to attract
as
well
as
pension
fund
At present the market capitalization of the REIT
industry is too small to attract the larger investors, and the
institutions want the kind of control over their investments
that they receive with direct ownership.
However, the smaller
pension funds should generate some growth in the industry.
One
advisor
institutional
suggested
that
pension
plans
allocating $150MM or less to real estate should consider REIT
investment [38].
there
Based on a recent Coopers & Lybrand study,
are approximately
45,000
qualified
retirement
plans
around the country.
A final question that should be asked is what will the
role of the traditional sources of real estate financing be
70
in the future.
If cheaper sources of capital are available,
private owners of real estate will be much more hesitant to
form REITs.
Outlook for Growth in the Industry:
According
to
Robinson,
"Bruce
Garrison
originally
believed in public REIT capitalization of $40 billion by the
end of the 1990's.
Now I think that the impediments may be
stacking up too much to reach that level, and in the short
run, I am somewhat pessimistic on growth in the industry.
costs of forming an equity REIT today are severe.
The
However,
in the long run, I think that there will be significant growth
in the industry because REITs
capital."
71
provide a needed source of
Part Four
Perspective of a former
Estate Operating Company
President
& CEO of
a Public Real
The following is a highlighted version of a speech
which was presented by Tom Steele to the NAIOP Conference in
February of 1992.
M.I.T's
Center
position,
for
Steele
Mr. Steele is currently the Chairman of
Real
was
Investment Properties'
Estate.
the
Prior
President
which is
to
and
assuming this
CEO
of
Perini
a publicly held real estate
operating company closely resembling an equity REIT.
speech
titled
Publicly
Traded
Real
Estate
Companies
His
An
Owner/Manager's Perspective focused on some of the impediments
to operating a quasi-equity REIT.
Perspective on Public Market Valuation and a REIT's Ability
to Raise Ongoing Capital:2
Public real estate operating companies and REITs tend
Perini Investment Properties was formed to own and
operate income producing properties previously held by the
The properties were spun out
parent company, Perini Corp.
from the parent primarily for accounting reasons as the
(due to
negative net worth of the income properties
accelerated depreciation) was negatively affecting the
parent's share price. The properties were generating a healthy
cash flow after debt service.
Note: This issue is being focused on from an internal
managers perspective and not whether the market valuation is
appropriate.
2
72
to
trade
at
significant
discounts
to
net
current
value'
primarily due to the difference between appraisal based and
public market valuations (See Figure 3).
Appraisals tend to
rightfully look at longer trends and not be overly influenced
by current market fluctuations, while the stock market tries
to value long run trends instantaneously.
The stock market
also tends to overreact during particular economic cycles.
Based on these valuation issues, my [Steele's] conclusion is
that it is difficult to use the equity market as a source of
capital for many REITs because REITs will frequently trade at
a substantial
discount
from
what
their
management
perceive is a reasonable proxy for liquidation value.
teams
Unless
the market's valuation of the properties, in comparison to net
current value, closes to the 10-15% range, most management
teams will not accept the dilution of net current value that
issuing additional shares at market price will entail.
This
problem is exacerbated during adverse economic and industry
conditions.
So, in many cases, outside of providing initial
capital, the market does not provide an ongoing opportunity
for liquidity. [Based on the model in Chapter 3, current stock
market valuations are in the range of
10-15% of appraised
value.]
I Net Current Value refers to the value of the REIT
This value is contrasted
assets based on current appraisals.
to book value and the public market's valuation through share
price.
73
Other Issues:
1.
Reporting of Results to Shareholders
At Perini Investment Properties, we believed that cash flow
and appraised value were the most relevant tracks for our
However, Dow Jones and the Wall Street
investors to follow.
Journal would never carry our results because they had a
policy of only reporting earnings per share under GAAP.
1
This
meant that as quarterly and year-end results became available,
ours were not carried by the traditional wire services.
2.
Impact of Limited Float
Only about 1.5 million of our 4 million shares was readily
available to trade, and this restricted interest in our stock
We weren't
to smaller investors.
large
enough to attract the larger institutions.
have
been
a
ultimately.
benefit
capitalization,
REIT
share
prices
enough or
However, this may
to
Due
can
liquid
get
their
hit
small
hard
by
institutional selling pressure.
3.
Takeover Issues
Being public, and being perceived as undervalued subjected the
company to unwanted
attention by takeover
firms who were
taking advantage of the availability of junk bond financing.
Whether this was efficient or not from a market point of view
is debatable.
However,
it
did threaten to take control of the
Generally Accepted Accounting Principles.
74
future of the company out of management's hands, and required
enormous
to
attention
of
diversions
ultimately
was
what
unproductive effort.
4.
Responding to Equity Analysts and Industry Specialists
Being public creates a whole new level of constituencies that
require attention and feeding.
In
addition to the usual
constituencies we all have by being in the business, i.e;
employees, partners, lenders and tenants, there is a whole
raft of analysts and shareholders that need to be serviced by
the
company.
Analysts
and
specialists
industry
personal attention by top management.
require
If you can't use the
market for additional equity, I question the value of these
efforts.
5.
Incremental Cost of Being Public
in
the
were
not
The -incremental cost of being public was somewhere
range
of
$250-400
thousand
annually,
and
we
extravagant in hiring financial public relations firms.
costs do
not
include
the
incremental
costs of
These
legal
and
investment banking help in dealing with take-over threats.
If
the company can't
access
the market,
are
these
costs
justified merely to provide liquidity for our shareholders?
75
CHAPTER 5:
The Future Role of Pension Fund Investment in the
REIT Industry: Perspectives of Two Institutional
Advisors
The increase in initial public offerings of equity
REITs will be driven in
real
estate
part by the demand for securitized
from tax-exempt investors.
At present,
tax-
exempt investors account for only $2 BN of investment in the
One of
REIT industry out of a total market cap. of $15 BN.
the primary reasons for the lack of pension investment in
REITs is the small relative size of the REIT industry.
There
is a lot of discussion in the industry at present that many
of the advisors will be forming REITs from their assets under
management which would substantially expand the industry.
As
of 9/91, real estate advisory firms had $120 BN of tax exempt
funds under management.'
However,
these
public
also
offerings
impediments to the firms which are involved.
involve
I interviewed
two institutional advisors to get their perspective on the
demand for REIT investment from the pension funds and what the
prospects are for advisory firms creating equity REITs from
existing pools of managed assets.
I Source:
Investments.
September
1991
76
issue
of
Pensions
&
Part One
The Institutional Advisor Specializing in REIT Investment
On June 10,
Vice
President
1992,
with
Advisors Corporation.
I met with Keith Pauley who is a
Alex.
Brown
Kleinwort
Benson
Realty
Mr. Pauley manages approximately $150
million of pension assets which are invested solely in
Our conversation was centered on the
role of
REITs.
pension fund
investment as a catalyst for growth in the REIT industry.
The
following is a summary of our discussion:
Role of Institutional Players in the REIT Industry:
The small capitalization of the equity REIT market is
a major impediment to REIT investment by the largest pension
funds.
or
However, for funds which are allocating $150 million
less to
real
estate investment, REITS
provide the best
investment vehicle.
Conceptually the public plans have not
decided about REITS.
The public funds only have $2BN invested
in real estate securities at present.
to
grow
substantially
to
attract
The REIT market needs
more
institutional
investment.
The institutional owners and managers of real estate,
such as the insurance companies, banks
and advisory firms,
can rapidly expand the REIT industry by taking their holdings
public.
Specifically,
Capital, PRISA,
to REITs.
Hancock,
and JMB have all
LaSalle
Partners,
G.E.
looked at converting holdings
However, all have shied away from going public for
77
In my opinion, the primary reason for this is
the meantime.
that the institutions don't want to accept the value that the
stock market
is
currently
offering
for
real
estate.
In
addition, they are still too involved with trying to get a
handle on their existing problems.
(Another explanation put forward to explain why some
advisory
firms
have
not
converted
their
assets
under
management to REITs is that the cultural impediments involved
are too great.
Specifically, the institutions have not been
willing to allow a separate REIT management team to have full
control over the assets.
In addition, institutions have not
wanted to lose the expertise of
a few successful managers
which would be needed to run the REIT.
A related issue is
that managers running the REIT would be compensated far above
the level of their contemporaries in the institution, which
has created friction [46].)
Primary Benefits of REITs for Pension Fund Investors:
1.
Liquidity & Diversification
REITs offer both liquidity and diversification.
A smaller
pension fund is able to create a diversified real
estate
portfolio with liquidity that would not be available through
direct property investment.
In terms of liquidity, REITS are
a liquid investment whereas today, many commingled funds can't
meet their redemption requirements (See Figure 10 on next page
which shows the decline in redemptions and contributions).
78
Figure 10
Annual Contributions & Redemptions for
Selcted Open-End Commingled R.E. Funds,
$1.80
----------.. ----------------. ---------------.. -----------------. -----------------...
-----------------. ----------------- ------------.
$1.60
$1.40
$1.20
$1.00
$0.80
$0.60-
$0.40-
$0.20-
$0.00-
1983
1984 1985 1986 1987 1988 1989
* Contributions
U Redemptions
79
Source: Frank Russell Company
1990
6/91
2.
Flexibility
REITs offer the investor the ability to change
strategies.
For example,
investment
an investor could sell
off his
holdings in office REITS and buy into apartment REITS if the
forecasts for the apartment market are more favorable.
A
commingled fund does not offer the same flexibility.
3.
Control
REITs offer pension funds (any investor) more control over
their investment than an investment in commingled funds.
One
of the benefits of public ownership is the voting authority
which is given to each investor.
(However,
the ownership
limitations imposed by the five or fewer rule limit the amount
of control that any one investor can have in a REIT.1)
4.
Access to Capital
In today's market, REITs have access to additional capital to
grow their portfolios through acquisitions. This will benefit
existing investors in a positive spread environment.
are
also able to secure corporate
loans
REITs
from banks where
traditional real estate investment vehicles may be unable to
obtain financing.
In addition, tax-exempt investors are not
subject to unrelated business income tax for investments in
REITs which are leveraged.
I The 5 or fewer rule stipulates that five or fewer REIT
shareholders can't own more than 50% of the outstanding stock
or the REIT will be subject to tax at the corporate level.
80
5.
Fees
Pension fund advisory fees are typically charged based on a
percentage of total assets under management while REIT fees
are charged on a transaction basis only.
Over a long holding
period, REIT fees would be lower in most cases.
Current Impediments to Pension Fund Investment in REITs:
1.
Small capitalization of the REIT market.
2.
Five or Fewer Rule
The five or fewer rule restricts the size of the positions
that U.S. pension funds can take in REITs.
Typically, REITs
impose a 10% individual ownership restriction as well.
This
constrains the market even more.
3.
Perception of Real Estate
Current psychology of the marketplace towards real estate
investment in general.
Many of the pension plans have reduced
their real estate allocations substantially or are pulling
back from real estate period.
Part Two
Another Institutional Advisor Perspective
On July 16, 1992, I interviewed Susan Hudson-Wilson
who is a Director of Aldrich, Eastman & Waltch (AEW).
In the
interview, we primarily discussed the outlook for new REITs
created by the advisory firms and the type of REITs which
pension plans would be most interested in investing in.
A
summary of our conversation follows:
Pension Fund Advisors' Interest in REITs:
According
to
Hudson-Wilson,
the
majority
of
the
advisory firms are presently working on some type of REIT
vehicle and she expects to see some advisor REITs successfully
brought to market by the end of the year.
Essentially, the
advisory firms are looking at REITs as a way to bring in new
business and augment existing business.
This is critical in
today's market when the bulk of pension plans are holding back
on their real estate allocations.
Today, plan sponsors are
demanding liquidity, and forming a REIT is the best way to
provide that liquidity.
However, there will still be a huge
market for the traditional form of real estate investment,
primarily in the separate account form.
Ms. Hudson-Wilson
expects the capitalization of the REIT industry to more than
double to approximately $100
BN by the end of the decade
primarily due to the entrance of the institutional REITs.
Attractiveness of REITs for Pension Investors:
According
associated
liquidity
with
and
to
Hudson-Wilson,
REIT
accurate
investors the
investment
the
for
valuation.
primary
pension
REITs
benefits
funds
offer
liquidity which has been lacking
direct property investment and co-mingled funds.
are
pension
from both
In addition,
REITs offer a precise value daily, and unlike appraisal based
valuations, the pricing is derived from a variety of capital
market sources.
Historical Performance of Advisory Firms:
With all
of the
negative publicity which advisory
firms have received in the past few years, I was curious as
to
why
the
relationships
plan
with
sponsors
the
would
want
advisory
to
firms.
continue
In
their
addition,
I
questioned why pension investors would invest in institutional
REITs
versus
already
in
the type
of smaller
existence.
After
equity REITs
all,
the
which are
performance
of
institutionally managed real estate, based on the Russell
NCREIF Index, has substantially under-performed equity REIT
investment on a total return and annual yield basis since 1978
(See Figure 4).
According to Hudson-Wilson, pension plan sponsors are
still
interested in working with selected advisory firms.
This is primarily because, in her opinion, advisory firms can
offer the institutional quality product that existing REITs
Hudson-Wilson
offer.
can't
a long
investors want
portfolio
of
run
property
and
geographical
of
creation
institutional
that
believes
based
value
on
a
diversified
type
These investors are not as interested in the existing
assets.
"mom and pop" type REITs which are very focused by both region
and property type.
hold
properties
quality".
In addition, the majority of REITs do not
can
which
advisory
The
be
firms
considered
can
"institutional
REITs
deliver
with
a
diversified asset base and institutional quality real estate.
An argument to the acceptance
of advisor REITs by
institutional investors is the return performance which the
advisors have provided in the past in comparison to equity
On a total return basis, the NAREIT equity
REIT returns.
index has outperformed the Russell-NCREIF index by 53% since
1978.
This historical performance does not bode well for
advisors
attempting
to
repackage
the
assets
same
and
management teams which delivered those results.
Impediments to Securitizing Existing Managed Assets:
Ms. Hudson-Wilson explained that the major impediment
to forming the advisor REITs today is getting management and
the
existing
pension
investors
offered by the public market.
to
accept
the
valuations
Real estate has to be priced
based on a market derived yield, not based on appraisals,
that can create
Hudson-Wilson,
some
valuation
"there is
shortfalls.
and
According to
a steep learning curve facing the
institutional side of the business concerning how REITs need
to be structured and priced."
She does not see the cultural
issues involved with converting assets under management into
REITs
as playing that big of
a factor.
"Essentially
the
entire process comes down to pricing and structure, and the
relatively minor cultural issues should not get in the way of
an otherwise solid transaction."
According to Hudson-Wilson, the five or fewer rule
also presents a substantial impediment to the formation of
REITs geared towards institutional investment.
the regulations consider U.S.
At present,
pension plans to be individuals,
not a collection of investors, and that is why the plans are
restricted.
Attempts have been made to get the designation
changed so that individual investor would apply to the members
of the pension plan.
Chris Lucas of NAREIT'
has indicated
that new legislation has been proposed which would create a
new
level
of
standards
for
pension
funds.
The
proposed
10%/25%/50% rule essentially proposes that a pension fund can
own up to 25% of a REIT, but no two plans combined could own
more than 50%.
Individual investors (excluding pension funds)
would be restricted to 10% ownership.
Violation of any of
these regulations by a REIT would result in taxation at the
corporate level [33].
is
expected, it
Although ultimate passage of the bill
is doubtful if
the legislation will be passed
during the current election year.
National Association of Real Estate Investment Trusts
85
Conclusion:
CHAPTER 6:
The Prospects for Growth
The equity REIT industry is positioned for tremendous
growth primarily due to the lack of other capital sources in
the marketplace.
no
access
to
Commercial real estate today has virtually
the
traditional
sources
of
financing which
include commercial banks, insurance companies,
extent,
direct
pension
fund
investment.
and to a lesser
Equity REITs
do
provide access to capital needed to fill the financing void,
however,
few private owners of real estate have the resources
to overcome the impediments to equity REIT formation in the
current market.
This is evidenced by the fact that the Kimco
Corporation offering in 1991 was the first new equity REIT
offering since 1978.
As the market improves and more demand is generated
for real estate investments, one can expect to see an increase
in equity REIT formations by private owners.
trend will
be
influenced
by the
role
of
However, this
the
traditional
financing sources and the availability of private capital at
lower costs.
For
converting
barriers
to
private
developers
partnership
assets
successfully
into
bringing
currently
a
an
REIT
considering
vehicle,
offering
to
the
market
include a minimum offering size in the range of $60 million
and hard dollar costs in the range of 8-10% of the market
value of the assets.
In addition, the typical valuation of
the
properties
offered
by
the
stock
market
involves
writedown of 10-15% from current appraised values.
a
On top of
the hard dollar costs, there are a myriad of intangible issues
as well.
The effort required to convert existing partnership
interests and the structure of REIT management required by the
public market, are
just two of the major issues involved.
Valuation issues, however, should be less of a burden in the
future as the market's perception of commercial real estate
improves and less restrictive pricing is available for new
offerings.
With the impediments
facing developers and smaller
private owners of commercial real estate considering equity
REIT
conversion,
managers
addition,
of
real
many
are
estate
the pension
as
looking
to
the
of
a source
funds demand for
institutional
offerings.
liquid real
In
estate
investments is often considered to be the catalyst needed to
rapidly expand the REIT industry.
In deed, REITs appear to
offer the type of real estate investment most suitable for
small to mid-sized tax exempt investors.
Most public REITs
provide the liquidity and accurate valuation which has been
missing from institutional portfolios.
However, in the short
term, the majority of tax-exempt investors are wary of real
estate
investments
in general.
On
the
supply
side, the
advisory firms are struggling with valuation and cultural
issues which are impeding the conversion of their assets under
management to the REIT vehicle.
It appears that in the long
term, many advisory firms will convert their managed holdings
to equity REITs as a way to maintain their market share and
retain existing clients.
So where does that leave the equity REIT industry?
In
my opinion, the equity REIT industry will grow substantially
by the end of the decade, perhaps doubling in size.
The need
for capital should overcome the short term impediments to new
offerings,
especially
for
the
institutional players.
In
addition, as the health of the commercial real estate industry
improves, more interest will be generated from the demand side
to grow the industry.
In the long term, the growth of the
equity REIT industry will
be dependent on the ability of
private owners to obtain non-recourse financing and the tax
driven
benefits
ownership.
historically
associated with
real
estate
If the changes in credit availability and the tax
laws remain in place, the U.S.
equity REIT industry will
expand to a market capitalization in line with securitized
real estate in other parts of the world.
88
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Those
New
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REIT